Behavioral finance lesson – frequent flyer points?

July 20, 2010 BY danariely

Here is an email that I got last week from a financial planner:

Dear Dan.

My hourly model lets clients use whatever retail custodian they like.  For various reasons, I tend to recommend the two best as Vanguard and Fidelity.  I go over the pros and the cons for each and, as soon as I mention Fidelity gives 25,000 frequent flyer miles, most clients stop me and choose Fidelity.  Some will move tens of millions to Fidelity in order to get frequent flyer miles that might have a $200 economic value (and I may be generous).  That would be the equivalent of 0.001% on a $20 million portfolio and .01% on a $2 million portfolio.

Any idea why this seems to have more impact than traditional economics might explain?


XXX, CFP®, CPA, MBA (name hidden)

Here is my (short) response

Dear XXX,

This phenomenon is what we call “medium maximization.”

The basic idea is that often people focus on near term concrete goals (such as frequent flyer miles), and while trying to maximize these immediate and clear goals they forget or discount the real reason for their actions — which in your case is maximizing their financial outcome. (For a great paper on medium maximization see this paper by Chris Hsee)

Why do people engage is such medium maximizations?  Because it is easy.  It gives people a clear direction for behavior — and just having something measurable within reach can redirect our motivation.  Another reason for the efficacy of medium maximization is that such immediate and concrete goals by which to measure ourselves against give us  a sense of progression ….

I am not sure whether this should make you more or less appreciative of your clients, but hopefully you can now understand them a bit better.  Or maybe it means that you should start offering them frequent flyer miles?

Irrationally yours


The Trouble with Cold Hard Cash

August 5, 2009 BY danariely

Motivating people is an extremely difficult and delicate task as anyone who’s ever taught, managed, collaborated with or given birth to someone knows. In business, as opposed to say, child-rearing, the debate is slightly less daunting, though not always much clearer. For instance, offering incentives to employees for improved performance is a fairly common approach to encouraging higher sales —though surprisingly unproven by data.

For the most part, the effectiveness of incentives is supported by intuition and some anecdotal evidence. Wouldn’t everyone work at least a little harder for a $100 bill on top of their usual paycheck? Certainly it can’t hurt. But one important open question is whether monetary or tangible (spa retreat, ipod, dinner for two, etc) rewards more efficacious motivators?

Those who advocate for monetary incentives claim they have the greatest appeal given that the winners can do anything with them; what if someone needs an ipod like they need another hole in their head? On the other side, those in favor of tangible incentives argued that money lacks the emotional appeal of, say, a weekend for two at a romantic country inn or swank hotel. But either way, there was nothing to back up either camp.

Thankfully, there is some data on this debate.  A few years ago Goodyear Tire & Rubber Company decided to test which method was more successful in an effort to improve sales of a new line of Aquatred tires. Their plan was simple and elegant: first they ranked their 60 retail districts according to previous sales, then divided them into two groups of equal performance and assigned one group to receive monetary incentives and the other to receive tangible incentives of equal value to the first group.

The results were very interesting; it turned out that the tangible-reward group increased sales by 46% more than the monetary-reward group. They also improved in terms of the mix of products sold by 37%. One explanation, and it seems to me a fairly good one, is that we can visualize tangible rewards (imagine yourself on a Hawaiian beach), which creates an emotional response. Money, on the other hand, is not accompanied by images as often (aside from maybe Scrooge McDuck swimming in piles of it), and lacks the emotional pull that tangible rewards have, so they’re less effective in motivating employees. I guess it’s called “cold, hard cash” rather than “future beach vacation cash” for a reason.

Why Bankers Would Rather Work for $0.00 Than $500K

April 17, 2009 BY danariely

Sometimes asking someone to do something for nothing is more powerful than paying them.

In a research paper entitled “Effort for Payment: A Tale of Two Markets,” James Heyman and I that people are willing to help move a couch or perform an experiment just by being asked. Moreover, these individuals feel good about their “gift”. Most interestingly, the experiments show that contrary to standard economic theory, paying a small incremental incentive does not increase effort, but actually lowers it — because meager compensation profanes the gift effect and disincents the giver.

Bringing money into the relationship takes the giver’s work out of “gift” market, and brings it into the “pay-for-effort” market. When it was done for nothing, the protagonist was a “donor.” When small money was on the table, he or she became an underpaid employee. The easiest way to think about this is to imagine if at the end of Thanksgiving dinner you asked your mother-in-law how much you owed her for cooking such a wonderful meal. Would that increase or decrease her effort the next time you came by? (Assuming, of course, she would still invite back you after such an insult.)

In this financial crisis, there has been much discussion about banker’s pay. We think that if President Obama had asked for a group of bankers to take $0, and paid expenses only, it would have brought the discussion back into the gift economy. $500,000 is just low enough to bruise the banker’s egos (after all, they got used to much higher salaries for a long time, higher salaries we can be pretty certain they feel they deserved), but $0 is something to be proud of! In fact, paying these CEOs nothing might remind them about the responsibility they have to the banks they are leading and to the rest of society. The CEO of AIG Ed Liddy is already only taking a one-dollar salary and donating his time to this worthy effort. But his gift is isolated, a drop in the bucket — not part of an overall “corps” of senior financial executives acting in unison to help fix the mess.

Would the best people be willing to work for free? Not all capable bankers could afford it, but many could. We think there would be many willing to pitch in…if asked in the right way. After all, this gift idea was at the core of John F. Kennedy’s brilliant notion, “Ask not what your country can do for you — ask what you can do for your country.” By eliminating pay altogether, these leaders would be giving the nation the donation of their time and skill, improving their level of motivation. Instead of accusing them of being greedy and self interested, people could see them as important actors playing key roles in the stability of our entire economy. This in turn would probably encourage more bankers to see the power of a collective gift and the joy they could feel in donating something so important.

As it stands now, the many good people who are trying to improve things for little or no pay are isolated, their effort drowned out by the outrage over bonuses and salaries. Hence we have the Congress and President involved in legislating the level of executive compensation all the way down to its structure and timing! Congress should not be mired in the details of compensation design. Not only are they bad at it, but the beleaguered public — whose median household income is less than 1/10th of $500,000 — is watching the pay ping pong with collective disgust. The knee-jerk reaction to create a confiscatory 90% tax on the AIG bonuses makes the conservatives among us think we are killing capitalism itself.

When individuals commit acts of personal generosity, it sparks a gift culture that replenishes a store of trust — a resource as multiplicative as any Keynesian monetary policy. This sharing is not done in a communist, carving-up-the-spoils manner, but rather in the tradition of bravery and sacrifice for our collective benefit. When those in power act within a gift culture guided by a spirit of generosity for common cause, it creates a tangible trust asset that supports the flow of credit, money, and markets. By focusing on limiting executive pay, President Obama did the political equivalent of asking his mother-in-law how much he owed her for Thanksgiving dinner — and moved the discussion away from social responsibility, and into the pay-for-effort market, where the negotiations for spoils now dominate the discourse.

We think our bold young President has to improve his request. A gift culture — created at the top — will benefit all of us; and, strangely, will also help strengthen the rapacious markets where self-interest reigns supreme. The good news is, it’s not too late.

By John Sviokla and Dan Ariely

Buffett and his attempts at self-control

March 23, 2009 BY danariely

I am teaching today in class about self control problems, and approaches to regain self control.  Here is a story of Buffett and his attempts at self-control:

Even the most analytical thinkers are predictably irrational; the really smart ones acknowledge and address their irrationalities. We find a great example in Alice Schroeder’s “The Snowball: Warren Buffett and the Business of Life.”

Warren Buffett is a numbers-driven investor whose life choices and business decisions would make the vulcan Mr. Spock seem over-emotional. A teenage horse handicapper who grew up into a deep reader of Moody’s and Standard and Poor’s reports, Buffett is the archetypal quant: a data-processing, information-consuming, hard-thinking, analytical machine. His ability to outperform the market by basing his decisions on hard data and on an uncanny understanding of business fundamentals earned him the moniker “Oracle of Omaha.”

Buffett’s success as an investor required not only deep analysis of financial documents but also a large measure of self-control to avoid getting caught in market bubbles and panics. Buffett’s rule “buy when everyone else is selling, sell when everyone else is buying” requires enormous self-assurance to execute.

And yet, even the Oracle of Omaha is not immune to the allure of irrational behavior. He is what Behavioral Economists call a sophisticate: someone who understands his irrationality and builds systems to cope with it. (The other types of people are the “rational,” who never deviates from optimal behavior, and the “naif,” who is unaware of his irrationality and therefore doesn’t do anything to address it.)

Uncommon a person as he was, Buffett had a very common concern: he feared gaining too much weight. Rational agents don’t gain weight because they always consider all the possible consequences of all actions. Naifs plan to start their diet tomorrow.

But Buffett — who breakfasted on spoonfuls of Ovaltine — understood his predictable irrationality: people eat without consideration for the long-term effects; that’s why they gain unwanted weight. Being a pragmatic person, he decided to curtail overeating with a commitment device.

He gave unsigned checks for $10,000 to his children, promising to sign them if he was over target weight by a certain date. Many people use commitment devices to try to keep their weight down, but Buffett’s idea had a big flaw: his children, spotting a rare opportunity to get money from the notoriously frugal billionaire, resorted to sabotage. Doughnuts, pizza, and fried food mysteriously appeared whenever Buffett was home.

In the end the incentives worked: even with his children’s sabotage, the Oracle kept his weight down, and his checks went unsigned. But had he been purely rational, no commitment device would have been needed.

Bankers’ salaries

February 15, 2009 BY danariely

In the wake of all this public anger over bankers’ salaries, and within weeks of taking office, Barack Obama is proposing “common sense” executive pay guidelines—at least in companies receiving government money. These measures call for executive salaries not to exceed $500,000; any further compensation could only be in the form of stocks, which can’t be sold until the government is paid back. No doubt this makes us feel better to some extent, but the question is, will it work?

I think not, and here’s why: if we were designing the stock market from scratch and offering people $500,000 a year plus stock incentives, I’m sure we would get lots of qualified people who would kill for this job, and not only for the salary but also as an important civil service to maintain the financial system on which we depend. But this is if we started from scratch, which we are most assuredly not. Instead we’re dealing with existing bankers who are accustomed to millions a year plus millions in stock options. These people have made up, over the years, a multitude of reasons why this is the least that they deserve for their efforts and skills (how many people can admit to being paid much more than they’re worth?). This is a problem of relativity. To these bankers, in view of their “normal” pay, it looks like an offensive and irresponsible offer. My guess is that they will not accept these conditions, or if they do, they’ll find other tricks to pay themselves what they think are “right” and fair wages, which is what they earned heretofore.

What would I have done if I’d been the financial czar in this situation? I would try to turn over a new leaf; incentivize the creation of new banks with a new pay structure; promote the idea that bankers are not greedy bastards but have a crucial social responsibility so that a whole new generation would take this approach and want these positions. The “old bankers” who feel they needed millions of dollars to do their jobs well could try and compete in this new market, but we’d see who actually wanted to bank with them when the alternative is a new bank with more idealistic underpinnings and a better, more realistic, and more transparent, salary structure.

HBR Breakthrough Ideas for 2009

February 5, 2009 BY danariely

HBR just came out with their Breakthrough Ideas for 2009.

One of my projects was selected to this list in 2008, and another was selected this year.

Here is the writeup of the project ….

Labor is not just a meaningful experience – it’s also a marketable one. When instant cake mixes were introduced, in the 1950s, housewives were initially resistant: The mixes were too easy, suggesting that their labor was undervalued. When manufacturers changed the recipe to require the addition of an egg, adoption rose dramatically. Ironically, increasing the labor involved – making the task more arduous – led to greater liking.

Our research shows that labor enhances affection for its results. When people construct products themselves, from bookshelves to Build-a-Bears, they come to overvalue their (often poorly made) creations. We call this phenomenon the IKEA effect, in honor of the wildly successful Swedish manufacturer whose products typically arrive with some assembly required.

In one of our studies, we asked people to fold origami and then to bid on their own creations along with other people’s. They were consistently willing to pay more for their own origami. In fact, they were so enamored with their amateurish creations that they valued them as highly as origami made by experts.

We also investigated the limits of the IKEA effect, showing that labor leads to higher valuation only when the labor is fruitful: When participants failed to complete an effortful task, the IKEA effect dissipated. Our research suggests that consumers may be willing to pay a premium for do-it-yourself projects, but there’s an important caveat: Companies hoping to persuade their customers to assume labor costs – for example, by nudging them toward self-service through internet channels – should be careful to create tasks difficult enough to lead to higher valuation but not so difficult that customers can’t complete them.

Finally, the IKEA effect has broader implications for organizational dynamics: It contributes to the sunk cost effect, whereby managers continue to devote resources to (sometimes failing) projects in which they have invested their labor, and to the not-invented-here syndrome, whereby they discount good ideas developed elsewhere in favor of their (sometimes inferior) internally developed ideas. Managers should keep in mind that the ideas they have come to love, because they invested their own labor in them, may not be as highly valued by their coworkers – or their customers.

What’s the Value of a Big Bonus?

November 20, 2008 BY danariely

From the NYT op-ed
BY withholding bonuses from their top executives, Goldman Sachs and UBS may soften negative reaction from Congress and the public if their earnings reports in December are poor, as is expected. But will they also suffer because their executives, lacking the motivation that big bonuses are thought to provide, will not do their jobs well? (more…)